Barter System

Money is something which is generally accepted as a medium of exchange. It is one of the most basic and significant inventions of mankind. Before money came into use, exchange took place through barter system, i.e., goods were exchanged for goods. Barter means direct exchange of goods. In other words, barter refers to exchanging of goods without the use of money. For example, corn may be exchanged for cloth, house for horses, bananas for oranges and so on.
What are the advantages of Barter System?

i. It is a simple system devoid of the complex problems of the modern monetary system. ii. There is no question of over or under-production (or of unemployment or over-hill employment) under the barter system since goods are produced just to meet the needs of the society. iii. The problems of international trade, such as, foreign exchange crisis, adverse balance of payments, do not exist under barter system. iv. There is no problem of concentration of economic power into the hands of a few rich persons under the barter system because there is no possibility of storing the commodities. v. Personal and natural resources are ideally utilised to meet the needs of the society without involving any wastage. vi. The barter system also reaps the benefits of division of labour because it represents a great step forward from a state of self- sufficiency hi which every man has to be a jack of all trades and master of none.
What are the difficulties of Barter System

Barter system involves various difficulties and inconveniences which are discussed below:
1. Double Coincidence of Wants:

Under barter system, a double coincidence of wants is required for exchange. In other words, the wants of the two persons who desire to exchange goods must coincide. For example, if person A wants to acquire shoes in exchange for wheat, then he must find another person who wants wheat for shoes. Such a double coincidence of wants involves great difficulty and wastage of time in a modern society, it rarely occurs. In the absence of a double coincidence of wants, the individuals under

barter system are compelled either to hold goods for long periods of time, or to make numerous intermediary exchange' in order to get finally the goods of their choice.
2. Absence of Common Measure of Value:

Even if it is possible to have the double coincidence of wants, the absence of a common measure of value creates great problem because a lot of time is wasted to strike a bargain. Since there is no common measure in terms of which the value of a commodity can be expressed, the problem arises how much wheat should be exchanged for how many pairs of shoes. In fact, under the barter system, every good must be expressed in terms of every other good. If, for example, there are 1000 goods in the economy, then, in the absence of monetary unit, every good can be exchanged for the remaining 999 goods. What is true for one good will be true for all other 999 goods.
3. Lack of Divisibility:

Another difficulty of barter system relates to the fact that all goods cannot be divided and subdivided. In the absence of a common medium of exchange, a problem arises, when a big indivisible commodity is to be exchanged for a smaller commodity. For example, if the price of a horse is equal to 10 shirts, then a person having one shirt cannot exchange it for the horse because it is not possible to divide the horse in small pieces without destroying its utility.
4. The Problem of Storing Wealth:

Under a barter system, there is absence of a proper and convenient means of storing wealth or value, (a) As opposed to storing of generalized purchasing power (in the form of money) in a monetary economy, the individuals have to store specific purchasing power (in the form of horses, shoes, wheat etc.) under the barter system which may decrease in value in the due course of time due to physical deterioration or a change in tastes, (b) It is very expensive to store specific goods for a long time, (c) Again the wealth stored in the form of specific goods may create jealousy and enmity among the neighbors or relatives.
5. Difficulty of Deferred Payments:

The barter system does not provide a satisfactory unit in terms of which the contracts about the deferred (future) payments are to be written. In an exchange economy, many contracts relate to future activities and future payments. Under barter system, future payments are written in terms of specific goods. It creates many problems. Chandler has mentioned three such problems: (a) It may create controversy regarding the quality of goods or services to be repaid in future, (b) The two parties may be unable to agree on the specific good to be used for repayment. (c) Both parties run the risk that the goods to be repaid may increase or decrease in value over the period of contract.

6. Problem of Transportation:

Another difficulty of barter system is that goods and services cannot be transported conveniently from one place to another. For example, it is not easy and without risk for an individual to take heaps of wheat or herd of cattle to a distant market to exchange them for other goods. With the use of money, the inconveniences or risks of transportation are removed.

Main disadvantages of Barter System

The initial stage of exchange is known as barter exchange. Under barter economy, the goods are exchanged for goods. This implies that if one wants some commodity, this can be exchanged only by giving some other commodity in exchange. In short, barter economy, signifies the exchange of goods through the medium of goods. These days, barter transactions have virtually disappeared. Many difficulties were faced during barter transactions. Generally, the main difficulties faced were as follows: 1. Lack of Double Coincidence of Wants: Barter transactions can be possible only when two persons desiring exchange of commodities should have such commodities which are mutually needed by each other. For example, if Ram wants cloth, which Shyma has, then Ram should have such commodity which Shyam wants. In the absence of such coincidence of wants, there will be no exchange. However, it is very difficult to find such persons where there is coincidence of wants. One had to face such difficulties in barter economy because of which this system had to be abandoned. 2. Luck of Division: The second difficulty of barter exchange relates to the exchange of such commodities which cannot be divided. For example, a person has a cow and he wants cloth, food grains and other items of consumption. Under such a condition, exchange can be possible only when he discovers a person, who is in need of a cow and has all such commodities, but it is very difficult to get such a person. Then how to affect the exchange. Similarly the second problem relates to the exchange of such commodities which cannot be divided into pieces, because in this kind of situation, a big commodity like cow cannot be divided into small pieces for making payment of the goods of smaller value. 3. Lack of a Common Measure of Value: The biggest problem in the barter exchange was the lack of common measure of value i.e., there was no such commodity in lieu of which all commodities could be bought and sold. In such a situation, while facilitating the exchange of a commodity its value was to be expressed in all

commodities, such as one yard cloth is equal to kilogram of potato etc. It was a very difficult proposition and made exchange virtually impossible. Now, with the discovery of money, this difficulty has been totally eliminated. 4. Lack of Store of Value: In a barter economy, the store of value could be done only in the form of commodities. However, we all know that commodities are perishable and they cannot be kept for a long time in the store. Because of this difficulty, the accumulation of capital or store of value was very difficult and without the accumulation of capital, economic progress could not be made. It is because of this reason that as long as barter system continued, significant progress was not made in the world anywhere.

Types of Money
Money can be described as a token or a payment option which is used in our society to settle debts and to pay for the services and commodities which are provided to us. In other words, money is the medium of exchange in our society which has also been accepted by the law. Money plays a pivotal role in a country's economy. The main functions of money are :

It is a medium of exchange It gives purchasing power to consumer to pay for goods and services It is a unit of account It is a unit measure of value. It is a standard of deferred payment

There are several kinds of money varying in liability and strength. The society has modified the money at different times and in this way several types of money are introduced. When there was ample availability of metals, metal money came into existence later it was substituted by the paper money. At different times, several commodities were used as the medium of exchange. So, it can be said that according to the needs and availability of means, the kinds of money has changed. There are 4 major types of money :

Commodity Money Fiat Money Fiduciary Money Commercial Bank Money

Commodity Money It is the simplest kind of money which is used in barter system where the valuable resources

fulfill the functions of money. The value of this kind of money comes from the value of resource used for the purpose. It is only limited by the scarcity of the resources. Value of this kind of money involves the parties associated with the exchange process. These money have intrinsic value. Whenever any commodity is used for the exchange purpose, the commodity becomes equivalent to the money and is called commodity money. There are certain types of commodity, which are used as the commodity money. Among these, there are several precious metals like gold, silver, copper and many more. Again, in many parts of the world, seashells (also known as cowrie shells), tobacco and many other items were in use as a type of money & medium of exchange. Ex : gold coins , beads , shells, pearls, stones, tea, sugar, metal Fiat Money The word fiat means the "command of the sovereign". Fiat currency is the kind of money which don't have any intrinsic value and it can't converted into valuable resource. The value of fiat money is determined by government order which makes it a legal instrument for all transaction purposes. The fiat money need to be controlled as it may affect entire economy of a country if it is misused. Today Fiat money is the basis of all the modern money system. The real value of fiat money is determined by the market forces of demand and supply. Ex : Paper money, Coins Fiduciary Money Today's monetary system is highly fiduciary. Whenever, any bank assures the customers to pay in different types of money and when the customer can sell the promise or transfer it to somebody else, it is called the fiduciary money. Fiduciary money is generally paid in gold, silver or paper money. There are cheques and bank notes, which are the examples of fiduciary money because both are some kind of token which are used as money and carry the same value. Commercial Bank Money Commercial Bank money or demand deposits are claims against financial institutions that can be used for the purchase of goods and services. A demand deposit account is an account from which funds can be withdrawn at any time by cheque or cash withdrawal without giving the bank or financial institution any prior notice. Banks have the legal obligation to return funds held in demand deposits immediately upon demand (or 'at call'). Demand deposit withdrawals can be performed in person, via cheques or bank drafts, using automatic teller machines (ATMs), or through online banking. There are also various other types of money like the credit money, electronic money, coin and paper money, Fractional money and Repesentative money as discussed below : Fractional Money

It is a hybrid type of money which is partly backed by a commodity and has a fiat money transaction purpose. If the commodity loses its value then Fractional money converts into Fiat money. REPRESENTATIVE MONEY It represents a claim on commodity and it can be redeemed for that commodity at a bank . It is a token or paper money that can be exchanged for a fixed quantity of commodity. Its value depends on the commodity it backs. Coins Metals of particular weight are stamped into coins. There are various precious metals like gold, silver, bronze , copper whose coins are already used in human history. The minting of coins is controlled by the state. Paper Money Paper money don't have any intrinsic value , as a fiat money it is approved by government order to be treated as legal tender through which value exchange can happen. Governments print the paper money according to the requirements which is tightly controlled as it can affect the economy of the country. Interesting facts about various types of money : In China cowry shells are regarded as money during 1000 B.C to 1200 B.C. Leather bags are treated as money in the ancient city of Carthage. Copper coins are treated as money by Romans 600B.C. Silver coins are treated as money by Ancient Persians between 600-300 B.C. Gold Coins are treated as money in 600 B.C in Anatolia (Asian Turkey or Asia Minor ) Paper Money first appeared in China about 800 AD . In Europe, Sweden is the First country to issue Paper Money in 1661.

What are the important functions of Money ?

Various functions of money can be classified into three broad groups: (a) Primary functions, which include the medium of exchange and the measure of value; (b) Secondary junctions which include standard of deferred payments, store of value and transfer of value; and

(c) Contingent functions which include distribution of national income, maximization of satisfaction, basis of credit system, etc. These functions have been explained below:
1. Medium of Exchange:

The most important function of money is to serve as a medium of exchange or as a means of payment. To be a successful medium of exchange, money must be commonly accepted by people in exchange for goods and services. While functioning as a medium of exchange, money benefits the society in a number of ways: (a) It overcomes the inconvenience of baiter system (i.e., the need for double coincidence of wants) by splitting the act of barter into two acts of exchange, i.e., sales and purchases through money. (b) It promotes transactional efficiency in exchange by facilitating the multiple exchange of goods and services with minimum effort and time, (c) It promotes allocation efficiency by facilitating specialization in production and trade, (d) It allows freedom of choice in the sense that a person can use his money to buy the things he wants most, from the people who offer the best bargain and at a time he considers the most advantageous.
2. Measure of Value:

Money serves as a common measure of value in terms of which the value of all goods and services is measured and expressed. By acting as a common denominator or numeraire, money has provided a language of economic communication. It has made transactions easy and simplified the problem of measuring and comparing the prices of goods and services in the market. Prices are but values expressed in terms of money. Money also acts as a unit of account. As a unit of account, it helps in developing an efficient accounting system because the values of a variety of goods and services which are physically measured in different units (e.g, quintals, metres, litres, etc.) can be added up. This makes possible the comparisons of various kinds, both over time and across regions. It provides a basis for keeping accounts, estimating national income, cost of a project, sale proceeds, profit and loss of a firm, etc. To be satisfactory measure of value, the monetary units must be invariable. In other words, it must maintain a stable value. A fluctuating monetary unit creates a number of socio-economic problems. Normally, the value of money, i.e., its purchasing power, does not remain constant; it rises during periods of falling prices and falls during periods of rising prices.

3. Standard of Deferred Payments:

When money is generally accepted as a medium of exchange and a unit of value, it naturally becomes the unit in terms of which deferred or future payments are stated. Thus, money not only helps current transactions though functions as a medium of exchange, but facilitates credit transaction (i.e., exchanging present goods on credit) through its function as a standard of deferred payments. But, to become a satisfactory standard of deferred payments, money must maintain a constant value through time ; if its value increases through time (i.e., during the period of falling price level), it will benefit the creditors at the cost of debtors; if its value falls (i.e., during the period of rising price level), it will benefit the debtors at the cost of creditors.
4. Store of Value:

Money, being a unit of value and a generally acceptable means of payment, provides a liquid store of value because it is so easy to spend and so easy to store. By acting as a store of value, money provides security to the individuals to meet unpredictable emergencies and to pay debts that are fixed in terms of money. It also provides assurance that attractive future buying opportunities can be exploited. Money as a liquid store of value facilitates its possessor to purchase any other asset at any time. It was Keynes who first fully realised the liquid store value of money function and regarded money as a link between the present and the future. This, however, does not mean that money is the most satisfactory liquid store of value. To become a satisfactory store of value, money must have a stable value.
5. Transfer of Value:

Money also functions as a means of transferring value. Through money, value can be easily and quickly transferred from one place to another because money is acceptable everywhere and to all. For example, it is much easier to transfer one lakh rupees through bank draft from person A in Amritsar to person B in Bombay than remitting the same value in commodity terms, say wheat.
6. Distribution of National Income:

Money facilitates the division of national income between people. Total output of the country is jointly produced by a number of people as workers, land owners, capitalists, and entrepreneurs, and, in turn, will have to be distributed among them. Money helps in the distribution of national product through the system of wage, rent, interest and profit.
7. Maximization of Satisfaction:

Money helps consumers and producers to maximize their benefits. A consumer maximizes his satisfaction by equating the prices of each commodity (expressed in terms of money) with its

marginal utility. Similarly, a producer maximizes his profit by equating the marginal productivity of a factor unit to its price.
8. Basis of Credit System:

Credit plays an important role in the modern economic system and money constitutes the basis of credit. People deposit their money (saving) in the banks and on the basis of these deposits, the banks create credit.
9. Liquidity to Wealth:

Money imparts liquidity to various forms of wealth. When a person holds wealth in the form of money, he makes it liquid. In fact, all forms of wealth (e.g., land, machinery, stocks, stores, etc.) can be converted into money.

What are the qualities of good money material?

To be able to perform the functions of money well, the money material must possess the following qualities:
1. General Acceptability:

The material of which money is made should be acceptable to all without any hesitation. In this connection, gold and silver are considered as good money material because they are readily acceptable to the general public. Apart from being used as money, these metals can also be put to other uses (e.g., making ornaments.)
2. Portability:

Money should be easily carried or transferred from one place to another. In other words, the money material must have large value in small bulk. On this ground, various animals cannot be used as money.
3. Durability:

Money material must last for a long time without losing its value. Ice and fruits cannot become good money because they lose their value with the passage of time. Ice melts and fruits perish.
4. Divisibility:

Money material must be easily sub-divided to allow for the purchase of smaller units of the commodities. Cows, for example, cannot function as good money because a cow cannot be divided without losing its value; a fraction of cow is quite different entity than a whole cow.

5. Homogeneity:

Money should be homogeneous. Its units should be identical; they should be of equal quality and physically indistinguishable. If money is not homogeneous, the individuals will not be certain of what they are receiving when they make transactions.
6. Cognisability:

Money should be easily recognized. If it is not easily recognisable, it would be difficult for the individuals to determine whether they are dealing with money or some inferior asset.
7. Stability:

The value of money should remain stable and should not change for a long period of time. If the value of money is not stable, it will not be able to function as a measure of value, as a store of value and as a standard of deferred payment.
8. Malleability:

The money material should be capable of being melted and put to different forms. Gold, silver, copper, etc., have this quality. The precious metals, gold and silver by and large, possess the above mentioned qualities of good money material. It is because of this reason, that these metals have been used as money for a considerably long period of time. Now the notion of money has changed. The modern governments go through trial and error procedures before adopting a common medium of exchange. The main considerations for selecting a money material are general acceptability and cost of producing money. That commodity is chosen to serve as money which will be widely used by the people and which offers the least costly benefits of a common medium of exchange.

Liquidity explained
Liquidity indicates how quickly an asset can be converted into cash. Liquidity is a desirable trait to investors, and so generally the more liquid an asset the lower the return it offers, due to investors bidding up its price. Coins and banknotes are the most liquid assets. They do not pay interest or appreciate in value, unless they become old and of interest to collectors. Selling antique coins will require a trip to a specialized dealer, a valuation, and a sale by auction or commission, all of which cost money. A collection of rare coins is therefore far less liquid than a holdall stuffed with dollar bills, since it is expensive to turn a coin collection into ready money.

Liquid markets

Liquidity is also used in a closely related way to describe how easily assets can be traded. The markets in which those assets are traded can be described in terms of this liquidity. The most liquid markets have a high turnover of assets and many participants, and the cost of doing business in them is lower. To return to the example of a coin collection, most towns will only have one or two coin dealers, who will only be able to deal in a limited volume of coins. The antique coin market is many times less liquid than the international currency markets, in which billions can change ownership at a keystroke. The market in government bonds is similarly extremely liquid. With shares, the situation varies. Millions of shares in the leading blue chip companies are bought and sold every day in normal circumstances this market is very liquid. The difference between the buying and selling price of the shares (known as the bid-offer spread) is tiny, as market makers in large caps can do profitable business on small margins due to the sheer volume of shares being traded. In contrast, the shares of small companies are traded in lower volumes, with just a few thousand shares of some companies changing ownership in a typical day. As a result, market makers charge more to cover the cost of providing a market in these small cap shares, reflected in a wider spread. An investor buying a tranche of shares in a small cap can easily see his capital eroded by 5% or more in the trip from cash to ownership of such shares because of this spread. The small cap market is far less liquid than that of large cap shares. Prices are more volatile in less liquid markets, as a small number of participants can have a great influence on the price. Assets can be very widely held but still not be very liquid. Residential property is not an especially liquid market: relatively few homes change hands each year, buyers and sellers must pay all kinds of fees, and it can take months for a house to change hands. When house prices fall and nobody wants or can afford to move, turnover may grind to a near-halt. At such times the market has become illiquid.
INTEREST RATE The rate of interest measures the percentage reward a lender receives for deferring the consumption of resources until a future date. Correspondingly, it measures the price a borrower pays to have resources now.

Suppose I have $100 today that I am willing to lend for one year at an annual interest rate of 5 percent. At the end of the year, I get back my $100 plus $5 interest (0.05 100), for a total of $105. The general relationship is:

Money Today (1 + interest rate) = Money Next Year We can also ask a different question: What is the most I would pay today to get $105 next year? If the rate of interest is 5 percent, the most I would pay is $100. I would not pay $101, because if I had $101 and invested it at 5 percent, I would have $106 next year. Thus, we say that the value of money in the future should be discounted, and $100 is the discounted PRESENT VALUE of $105 next year. The general relationship is:

Money Today = Money Next Year (1 + interest rate)

The higher the interest rate, the more valuable is money today and the lower is the present value of money in the future. Now, suppose I am willing to lend my money out for a second year. I lend out $105, the amount I have next year, at 5 percent and have $110.25 at the end of year two. Note that I have earned an extra $5.25 in the second year because the interest that I earned in year one also earns interest in year two. This is what we mean by the term compound interestthe interest that money earns also earns interest. Albert Einstein is reported to have said that compound interest is the greatest force in the world. Money left in interest-bearing investments can compound to extremely large sums. A simple rule, the rule of 72, tells how long it takes your money to double if it is invested at compound interest. The number 72 divided by the interest rate gives the approximate number of years it will take to double your money. For example, at a 5 percent interest rate, it takes about fourteen years to double your money (72 5 = 14.4), while at an interest rate of 10 percent, it takes about seven years. There is a wonderful actual example of the power of compound interest. Upon his death in 1791, Benjamin Franklin left $5,000 to each of his favorite cities, Boston and Philadelphia. He stipulated that the money should be invested and not paid out for one hundred to two hundred years. At one hundred years, each city could withdraw $500,000; after two hundred years, they could withdraw the remainder. They did withdraw $500,000 in 1891; they invested the remainder and, in 1991, each city received approximately $20,000,000. What determines the magnitude of the interest rate in an economy? Let us consider five of the most important factors.

1. The strength of the economy and the willingness to save. Interest rates are determined in a FREE MARKET where SUPPLY and DEMAND interact. The supply of funds is influenced by the willingness of consumers, businesses, and governments to save. The demand for funds reflects the desires of businesses, households, and governments to spend more than they take in as revenues. Usually, in very strong economic expansions, businesses desire to invest in plants and equipment and individuals desire to invest in HOUSING tend to drive interest rates up. During periods of weak economic conditions, business and housing INVESTMENT falls and interest rates tend to decline. Such declines are often reinforced by the policies of the countrys central bank (the Federal Reserve in the United States), which attempts to reduce interest rates in order to stimulate housing and other interest-sensitive investments. 2. The rate of inflation. Peoples willingness to lend money depends partly on the INFLATION rate. If prices are expected to be stable, I may be happy to lend money for a year at 4 percent because I expect to have 4 percent more purchasing power at the end of the year. But suppose the inflation rate is expected to be 10 percent. Then, all other things being equal, I will insist on a 14 percent rate on interest, ten percentage points of which compensate me for the inflation.1 Economist IRVING FISHER pointed out this fact almost a century ago, distinguishing clearly between the real rate of interest (4 percent in the above example) and the nominal rate of interest (14 percent in the above example), which equals the real rate plus the expected inflation rate. 3. The riskiness of the borrower. I am willing to lend money to my government or to my local bank (whose deposits are generally guaranteed by the government) at a lower rate than I would lend to my wastrel nephew or to my cousins risky new venture. The greater the risk that my loan will not be paid back in full, the larger is the interest rate I will demand to compensate me for that risk. Thus, there is a risk structure to interest rates. The greater the risk that the borrower will not repay in full, the greater is the rate of interest. 4. The tax treatment of the interest. In most cases, the interest I receive from lending money is fully taxable. In certain cases, however, the interest is tax free. If I lend to my local or state government, the interest on my loan is free of both federal and state taxes. Hence, I am willing to accept a lower rate of interest on loans that have favorable tax treatment. 5. The time period of the loan. In general, lenders demand a higher rate of interest for loans of longer maturity. The interest rate on a ten-year loan is usually higher than that on a one-year loan, and the rate I can get on a three-year bank certificate of deposit is generally higher than the rate on a six-month certificate of deposit. But this relationship does not always hold; to understand the reasons, it is necessary to understand the basics of bond investing. Most long-term loans are made via bond instruments. A BOND is simply a long-term IOU issued by a government, a corporation, or some other entity. When you invest in a bond, you are lending money to the issuer. The interest payments on the bond are often referred to as coupon payments because up through the 1950s, most bond investors actually clipped interest coupons from the bonds and presented them to their banks for payment. (By 1980 bonds with actual coupons had virtually disappeared.) The coupon payment is fixed for the life of the bond. Thus, if a one-thousand-dollar twenty-year bond has a fifty-dollar-per-year interest (coupon) payment, that payment never changes. But, as indicated above, interest rates do change from year to year

in response to changes in economic conditions, inflation, MONETARY POLICY, and so on. The price of the bond is simply the discounted present value of the fixed interest payments and of the face value of the loan payable at maturity. Now, if interest rates rise (the discount factor is higher), then the present value, or price, of the bond will fall. This leads to three basic facts facing the bond investor:
1. If interest rates rise, bond prices fall. 2. If interest rates fall, bond prices rise. 3. The longer the period to maturity of the bond, the greater is the potential fluctuation in price when interest rates change.

If you hold a bond to maturity, you need not worry if the price bounces around in the interim. But if you have to sell prior to maturity, you may receive less than you paid for the bond. The longer the maturity of the bond, the greater is the risk of loss because long-term bond prices are more volatile than shorter-term issues. To compensate for that risk of price fluctuation, longerterm bonds usually have higher interest rates than shorter-term issues. This tendency of long rates to exceed short rates is called the risk-premium theory of the yield structure. This relationship between interest rates for loans or bonds and various terms to maturity is often depicted in a graph showing interest rates on the vertical axis and term to maturity on the horizontal. The general shape of that graph is called the shape of the yield curve, and typically the curve is rising. In other words, the longer term the bond, the greater is the interest rate. This typical shape reflects the risk premium for holding longer-term debt. Long-term rates are not always higher than short-term rates, however. Expectations also influence the shape of the yield curve. Suppose, for example, that the economy has been booming and the central bank, in response, chooses a restrictive monetary policy that drives up interest rates. To implement such a policy, central banks sell short-term bonds, pushing their prices down and interest rates up. Interest rates, short term and long term, tend to rise together. But if bond investors believe such a restrictive policy is likely to be temporary, they may expect interest rates to fall in the future. In such an event, bond prices can be expected to rise, giving bondholders a capital gain. Thus long-term bonds may be particularly attractive during periods of unusually high short-term interest rates, and in bidding for these long-term bonds, investors drive their prices up and their yields down. The result is a flattening, and sometimes even an inversion, in the yield curve. Indeed, there were periods during the 1980s when U.S. Treasury securities yielded 10 percent or more and long-term interest rates (yields) were well below shorter-term rates. Expectations can also influence the yield curve in the opposite direction, making it steeper than is typical. This can happen when interest rates are unusually low, as they were in the United States in the early 2000s. In such a case, investors will expect interest rates to rise in the future, causing large capital losses to holders of long-term bonds. This would cause investors to sell

long-term bonds until the prices came down enough to give them higher yields, thus compensating them for the expected capital loss. The result is long-term rates that exceed shortterm rates by more than the normal amount. In sum, the term structure of interest ratesor, equivalently, the shape of the yield curveis likely to be influenced both by investors risk preferences and by their expectations of future interest rates.
MONETARY POLICY

EXPANSIONARY MONETARY POLICY:

A form of monetary policy in which an increase in the money supply and a reduction in interest rates are used to correct the problems of a business-cycle contraction. In theory, expansionary monetary policy can include buying U.S. Treasury securities through open market operations, a decrease in the discount rate, and a decrease in reserve requirements. In theory, open market operations are the primary tool of expansionary monetary policy. Expansionary monetary policy is often supported by expansionary fiscal policy. An alternative is contractionary monetary policy. Expansionary monetary policy is an increase in the quantity of money in circulation, with corresponding reductions in interest rates, for the expressed purpose of stimulating the economy to correct or prevent a business-cycle contraction and to address the problem of unemployment. In days gone by, monetary policy was undertaken by printing more paper currency. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking.

The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations (buying U.S. Treasury securities), a lower discount rate, and lower reserve requirements. In practice, the Fed primarily uses open market operations for this control. An important side effect of expansionary monetary policy is control of interest rates. As the quantity of money increases, banks are willing to make loans at lower interest rates.
Open Market Operations Open market operations are the buying and selling of U.S. Treasury securities as a means of controlling bank reserves, the money supply, and interest rates. This policy tool is directed by the Federal Open Market Committee and implemented by the Domestic Trading Desk of the New York Federal Reserve Bank. Because open market operations are flexible, easily implemented, and quite effective they are the Fed's primary monetary policy tool.

Expansionary monetary policy occurs when the Fed buys U.S. Treasury securities through open market operations. The Fed pays for these Treasury securities with bank reserves, which results in an increase in total amount of reserves held by the banking system. Banks are inclined to lend

these extra reserves at lower interest rates, which increases checkable deposits and the money supply.
Discount Rate The discount rate is the interest rate that the Federal Reserve System charges commercial banks for reserve loans. The Federal Reserve System was established in part to provide commercial banks on the brink of failing with reserve loans. The discount rate is officially set by the Federal Reserve Banks, subject to approval by the Board of Governors. In practice, though, changes in the discount rate are coordinated with other monetary policy actions.

Expansionary monetary policy occurs when the Fed lowers the discount rate. This makes it easier for commercial banks to borrow reserves from the Fed. As with open market operations, the additional bank reserves held by the banking system induces more loans at lower interest rates, which increases checkable deposits and the money supply. However, because commercial banks do not undertake a great deal of reserve borrowing from the Fed, an increase in the discount rate alone is likely to have a limited impact on the money supply. For this reason, the discount rate is used primarily as a signal for other monetary actions, especially open market operations.
Reserve Requirements Reserve requirements are rules by the Fed specifying the amount of reserves that banks must keep to back up deposits. Reserve requirements are generally in the range of about 10 percent of checkable deposits and 0 percent of savings deposits. The primary reason for reserve requirements is to maintain the stability of the banking system and to avoid bank panics and other problems created when banks run short of reserves. The Board of Governors has authority over setting reserve requirements.

Expansionary monetary policy occurs when the Fed lowers reserve requirements. This means banks have more reserves than needed to back up deposits. They can then use these extra reserves to make more loans at lower interest rates, which increases checkable deposits and the money supply. Reserve requirements are an important part of the structure of the banking system. Banks commit to long-term, multi-year loans based on existing and expected reserve requirements. If the Fed changed reserve requirements frequently, then either the banking system will be unstable or banks will simply target the highest expected reserve requirements. For this reason, reserve requirements are seldom used as a monetary policy tool.
Stimulating The Economy All three tools, used separately or together, increase the amount of money in circulation and reduce interest rates. This combination of extra money and lower interest rates stimulate the economy by inducing additional expenditures on aggregate production, especially consumption expenditures and investment expenditures. With greater aggregate production, more resources are used, employment is greater, and unemployment declines.

This is precisely the stimulation needed of the economy is in a business-cycle contraction or recession with high unemployment rates. It is also recommended if the economy appears to be headed toward a business-cycle downturn. In fact, because monetary policy does not affect the economy immediately, implementing expansionary monetary policy before the economy a contraction sets it is the preferred strategy. In this way the recession and higher unemployment are not just "fixed," but avoided completely.
Other Policy Options Expansionary monetary policy is one of several stabilization policies available to the federal government to address business-cycle problems. Congress and the President can also get into the act of stimulating the economy through expansionary fiscal policy. Or the Federal Reserve can direct actions toward the inflationary problems through contractionary monetary policy.

Expansionary Fiscal Policy: An alternative means of stimulating the economy is expansionary fiscal policy. This includes an increase in government spending and/or a decrease in taxes. Both actions increase aggregate expenditures, aggregate production, and employment. Expansionary fiscal policy can be used to complement expansionary monetary policy or as an alternative.

Contractionary Monetary Policy: Monetary policy can also be used to address inflationary problems created by an overheated business-cycle expansion. Contractionary monetary policy is the opposite of expansionary monetary policy. It consists of selling U.S. Treasury securities through open market operations, raising the discount rate, and increasing reserve requirements. The resulting decrease in the money supply and increase in interest rates decreases aggregate expenditures, aggregate production, and thus reduces inflationary pressures.

CONTRACTIONARY MONETARY POLICY:

A form of monetary policy in which a decrease in the money supply and a increase in interest rates are used to correct the inflationary problems of a business-cycle expansion. In theory, contractionary monetary policy can include selling U.S. Treasury securities through open market operations, an increase in the discount rate, and an increase in reserve requirements. In theory, open market operations are the primary tool of contractionary monetary policy. Contractionary monetary policy is often supported by contractionary fiscal policy. An alternative is expansionary monetary policy. Contractionary monetary policy is a decrease in the quantity of money in circulation, with corresponding increases in interest rates, for the expressed purpose of putting the brakes on an overheated businesscycle expansion and to address the problem of inflation. In days gone by, monetary policy was undertaken by decreasing the amount of paper currency in circulation. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking.

The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money

supply through open market operations (selling U.S. Treasury securities), a higher discount rate, and higher reserve requirements. In practice, the Fed primarily uses open market operations for this control. An important side effect of contractionary monetary policy is control of interest rates. As the quantity of money decreases, banks are willing to make loans at higher interest rates.
Open Market Operations Open market operations are the buying and selling of U.S. Treasury securities as a means of controlling bank reserves, the money supply, and interest rates. This policy tool is directed by the Federal Open Market Committee and implemented by the Domestic Trading Desk of the New York Federal Reserve Bank. Because open market operations are flexible, easily implemented, and quite effective they are the Fed's primary monetary policy tool.

Contractionary monetary policy occurs when the Fed sells U.S. Treasury securities through open market operations. The Fed collects payment for the Treasury securities sold with bank reserves, which results in a decrease in total amount of reserves held by the banking system. Banks are inclined to reduce lending with fewer reserves, and charge higher interest rates, which decreases checkable deposits and the money supply.
Discount Rate The discount rate is the interest rate that the Federal Reserve System charges commercial banks for reserve loans. The Federal Reserve System was established in part to provide commercial banks on the brink of failing with reserve loans. The discount rate is officially set by the Federal Reserve Banks, subject to approval by the Board of Governors. In practice, though, changes in the discount rate are coordinated with other monetary policy actions.

Contractionary monetary policy occurs when the Fed raises the discount rate. This makes it harder for commercial banks to borrow reserves from the Fed. As with open market operations, the resulting reduction in bank reserves held by the banking system induces fewer loans at higher interest rates, which decreases checkable deposits and the money supply. However, because commercial banks do not undertake a great deal of reserve borrowing from the Fed, an increase in the discount rate alone is likely to have a limited impact on the money supply. For this reason, the discount rate is used primarily as a signal for other monetary actions, especially open market operations.
Reserve Requirements Reserve requirements are rules by the Fed specifying the amount of reserves that banks must keep to back up deposits. Reserve requirements are generally in the range of about 10 percent of checkable deposits and 0 percent of savings deposits. The primary reason for reserve requirements is to maintain the stability of the banking system and to avoid bank panics and other problems created when banks run short of reserves. The Board of Governors has authority over setting reserve requirements.

Contractionary monetary policy occurs when the Fed raises reserve requirements. This means banks need to devote more reserves to back up deposits. This forces banks to make fewer loans at higher interest rates, which decreases checkable deposits and the money supply. Reserve requirements are an important part of the structure of the banking system. Banks commit to long-term, multi-year loans based on existing and expected reserve requirements. If the Fed changed reserve requirements frequently, then either the banking system will be unstable or banks will simply target the highest expected reserve requirements. For this reason, reserve requirements are seldom used as a monetary policy tool.
Restraining The Economy All three tools, used separately or together, decrease the amount of money in circulation and raise interest rates. This combination of less money and higher interest rates constrains the economy by inducing fewer expenditures on aggregate production, especially consumption expenditures and investment expenditures. With less aggregate production, fewer resources are used, employment is lower, and unemployment rises. However, most important, there is less pressure and prices, so inflation declines.

This is precisely the stimulation needed of the economy is in a business-cycle expansion that has overheated to the point of causing higher inflation rates. It is also recommended if the economy appears to be headed toward an increase in inflation. In fact, because monetary policy does not affect the economy immediately, implementing contractionary monetary policy before inflation sets it is the preferred strategy. In this way the inflation is not just "fixed," but avoided completely.
Other Policy Options Contractionary monetary policy is one of several stabilization policies available to the federal government to address business-cycle problems. Congress and the President can also get into the act of restraining the economy through contractionary fiscal policy. Or the Federal Reserve can direct actions toward the unemployment problems through expansionary monetary policy.

Contractionary Fiscal Policy: An alternative means of restraining the economy is contractionary fiscal policy. This includes a decrease in government spending and/or an increase in taxes. Both actions decrease aggregate expenditures, aggregate production, employment, and reduce inflationary pressures. Contractionary fiscal policy can be used to complement contractionary monetary policy or as an alternative.

Expansionary Monetary Policy: Monetary policy can also be used to address unemployment problems created by a business-cycle contraction. Expansionary monetary policy is the opposite of contractionary monetary policy. It consists of buying U.S. Treasury securities through open market operations, lowering the discount rate, and decreasing reserve requirements. The resulting increase in the money supply and decrease in interest rates increases aggregate expenditures, aggregate production, employment, and thus reduces unemployment.

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